Why do markets exist for the old equity shares of chapter 11 debtors, when the almost invariable result in large chapter 11 cases is that such shares are cancelled and become worthless? This article discusses several candidate hypotheses that might help explain this odd phenomenon.

The cartoon characters on "The Simpsons" understand that a chapter 11 filing is not good for the debtor's equity-holders.¹ Yet in countless large chapter 11 cases, including Enron Corp.,² WorldCom,³ UAL Corp.,⁴ Air Canada⁵ and Amerco,⁶ robust markets have developed in the old equity shares of the debtors. The enthusiasm for buying these shares is puzzling, because in most large corporate bankruptcy cases, the old equity shares' ultimate value is zero.

There are at least three potential explanations for this phenomenon: (1) the market is not efficient and investors do not act rationally, (2) buyers are rationally purchasing options on chapter 11 debtors and (3) the "find a bigger fool" theory of investing is driving the market. Each hypothesis is discussed below.⁷

Background

A fundamental principle of bankruptcy is that equity-holders of an insolvent entity are, by definition, "out of the money" and entitled to receive nothing in respect of their equity stakes in the debtor. "Equity comes last. Only in the rarest chapter 11 are all debts paid, and under absolute priority only if all debts are paid may equity receive anything."⁸ Whether a given debtor is insolvent is a factual question for the court. See In re Leap Wireless International Inc., 295 B.R. 135, 139 (Bankr. S.D. Cal. 2003) (finding appointment of equity committee unwarranted because debtor was "hopelessly insolvent").

It has not always been the case that holders of equity interests are likely to receive nothing in a large chapter 11 case. Shareholders in the 1980s frequently received equity in the reorganized debtor, but that changed in the 1990s, according to law professor Lynn LoPucki, due in part to the fact that "creditors have grown more strategic in upholding the absolute priority rule governing bankruptcy recovery."⁹ However, there is a countervailing recent trend involving the increasing use of "gifting plans," pursuant to which senior creditors elect to give some of the consideration they receive under the plan to junior creditors and sometimes to equity-holders, even though the senior creditors are under no obligation to do so.¹⁰ If gifting plans become more widely used, the likelihood of equity-holders receiving at least a token recovery in chapter 11 may increase.

The Market May Not Be Efficient

The efficient market hypothesis (EMH) provides a fundamental way of understanding how markets work. A concise definition of the EMH is as follows: Asset prices in an efficient market "fully reflect all available information."¹¹ If the market in shares of debtors in bankruptcy is efficient, it should incorporate the information that in the vast majority of instances, the value of old equity shares is zero.¹² Anecdotal evidence casts real doubt on the explanatory power of the EMH in this context. For example, a long-time investor in WorldCom bought shares in that company in late 2002, months after it had filed for chapter 11, when former Compaq executive Michael Capellas became WorldCom's chairman of the board and chief executive officer. The investor bought 10,000 shares for $0.20 each "in a turnaround play," apparently believing that "he'd get shares in the new company." He sold his shares after finding out from the company that this was not the case.¹³

Other examples of investor irrationality in this market are not difficult to find. In the Winstar Communications Inc. chapter 11 case, for instance, the price of old equity shares rose in reaction to the bankruptcy court's approval of a debtor-in-possession (DIP) financing facility.¹⁴ While this development was a positive event in the bankruptcy case (which nevertheless ended in liquidation), the approval of the DIP financing had no bearing on whether equity would recover anything (and it is difficult to understand why equity investors would think it was relevant to their ultimate recoveries).

Of course, evidence also exists that the market in old equity shares is not completely irrational. When UAL Corp. stated in a June 2003 regulatory filing that it was "highly likely" that its old equity shares would be cancelled under its reorganization plan, its stock declined by 58 percent.¹⁵ Similarly, when Air Canada announced in June 2003 that its restructuring would make its current stock worthless, share prices fell by 36 percent.¹⁶

But there is contrary evidence suggesting that irrational behavior by investors persists even at late stages of chapter 11 cases, when the ultimate fate of old equity has become clear. Enron Corp., et al., filed a reorganization plan on July 11, 2003. Old equity is deemed to reject the Enron plan because it is completely impaired under it; nevertheless, the share price rose by 70 percent and the trading volume increased by a factor of eight. Several months before, on April 22, 2003, Kmart Corp. announced that the bankruptcy court had confirmed its reorganization plan. Trading volume the next day reached 133 million shares, which was six times the average amount. Within a week, the share price for old equity had doubled (to $0.12), despite the fact that old equity was to be cancelled under Kmart's plan.¹⁷

A Method to the Madness?

Noting the apparent irrationality of investors in debtors' old equity shares is not a novel insight. For example, in 1993, a journalist was puzzled by a 50 percent increase in the share price of LTV Corp., which was then a debtor in its first chapter 11 case.¹⁸ Also in 1993, The Wall Street Journal observed that "stocks of companies operating under chapter 11 of the bankruptcy laws...have been trading lately at prices that market veterans say are irrationally high...much of the speculative activity comes from naïve investors."¹⁹

In examining this phenomenon of allegedly irrational investors and seeking a rational explanation for it, some finance scholars have argued that perhaps old-equity buyers are following a rational strategy of buying call options: "If we regard equity of a bankrupt firm as a deep out-of-the-money call option...equity should have a positive value. Accordingly, the positive market prices obtained [for old equity shares] may or may not be realistic."²⁰ These authors used the Black-Scholes options pricing model to generate predicted values for call options on the debtors' stock, and they then compared those predicted values with the actual share prices on the bankruptcy filing date for each debtor included in their study. Unfortunately, the research on buying old equity as a call option was somewhat inconclusive due to a lack of data regarding the market value of debtors' assets. The authors concluded that "based on some of our parameter estimates, Black-Scholes estimates tend to be greater than the observed market values [of old equity shares]."²¹ But the scholars cautioned that "crudeness of data and lack of information compound the [asset] valuation problem. When assets are valued at about 40 percent of liabilities, estimates tend to be less than the observed market values and would imply that investors in these bankruptcy firms are overpaying."²²

Finding a Bigger Fool

"Find a bigger fool" is another candidate hypothesis: It offers an appealing mixture of the rational and irrational. This explanation of market behavior states that buyers' stock purchases are motivated by the belief that they will be able to sell their stock to some other "fool" for a higher price. Thus, investor behavior is in one sense irrational because it is divorced from any analysis of the fundamentals of the stock that is bought and sold. On the other hand, investors are rationally calculating that they will be able to unload whatever shares they buy on someone else.

As a potential example of the "find a greater fool" hypothesis in action, consider the case of Fruit of the Loom Ltd. In November 2001, when Warren Buffett's Berkshire Hathaway Inc. offered to buy the company for $835 million, the price of old equity shares increased more than 75 percent on a volume of several million shares, despite the fact that Buffett's proposed purchase price was less than the amount of the debtor's $1.2 secured debt; i.e., the transaction did not offer the hope of any recovery for equity-holders. One commentator stated that some of the buyers of the shares "know the stock is worth zero. They want to profit from the ignorance of other investors who don't know the score. The sharpies figure they'll buy up the stock, then unload it for a big gain on those naïve or unknowing enough to believe that the Berkshire deal actually means something good for Fruit of the Loom shares."²³

Conclusion

A byproduct of the bankruptcy boom of the last two or three years has been a bull market in the old equity shares of chapter 11 debtors. The existence of this robust market is a puzzle, because in a typical chapter 11 case, holders of equity interests receive nothing under the reorganization plan. The thriving market in old equity shares may be a result of investor irrationality and lack of understanding of the bankruptcy process. Alternatively, it may reflect a rational strategy of buying out-of-the-money call options on chapter 11 debtors' stock. A third possibility is that the observed behavior is a product of a mixture of rational and irrational behavior as expressed in the "find a greater fool" hypothesis.

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Footnotes

¹ In a "Simpsons" episode, Homer Simpson buys shares in a company called Animotion. Soon thereafter, television broadcaster Kent Brockman announces that "[Animotion] declared super-dooper bankruptcy, which is terrible news for the company's only stockholder, Homer Simpson." "HOMR," Season 12 of "The Simpsons," originally broadcast Jan. 7, 2001. Return to article

² See "Millions of Enron Shares Still Being Sold—and Bought," Daily Bankruptcy Review, March 12, 2002, at 6. Return to article

³ See "At WorldCom, Shares May Die, but They Might Not Fade Away," The Wall Street Journal, April 15, 2003, at C3. Return to article

⁴ See "UAL Says 'Highly Likely' Shares Will Be Worthless," Reuters news story, June 10, 2003. Return to article

⁵ See "Air Canada: The Stock That's Refusing to Die," Reuters news story, June 12, 2003. Return to article

⁶ See "U-Haul's Parent Finds Equity Gains in Bankruptcy," New York Times, Aug. 20, 2003. Return to article

⁷ This list of hypotheses is not exhaustive. Another possible explanation for the observed behavior is that investors in chapter 11 debtors' shares are driven by tax considerations—i.e., they seek to acquire capital losses to reduce their tax liability. Return to article

⁸ Herbert, Michael J., Understanding Bankruptcy, §17.15[D][3] (1997). Return to article

⁹ Wei, Lingling, "Shareholders Become Active in Bankruptcy Actions," The Wall Street Journal Online, March 21, 2003. Return to article

¹⁰ For an example of a gifting plan, see debtors' amended joint reorganization plan, In re Pioneer Companies Inc., et al., Case No. 01-38259-H3-11, Southern District of Texas, Houston Division. Return to article

¹¹ Fama, E.F., "Efficient Capital Markets: II," Journal of Finance, 46(5), 1575-1617 (December 1991). Return to article

¹² An empirical study of 154 companies that filed for bankruptcy between 1984 and 1993 found that the common stockholders of 93 (i.e., 60 percent of the total) of the debtors received no consideration at the end of the bankruptcy. Russel, Philip S., Branch, Ben and Torbey, Violet, "Market Valuation of Bankrupt Firms: Is There an Anomaly?" Quarterly Journal of Business and Economics, No.2, Vol. 38 (March 1999). Return to article

¹³ Opdyke, Jeff D., "At WorldCom, Shares May Die, But They Might Not Fade Away," The Wall Street Journal, April 15, 2003, C3. Under WorldCom's reorganization plan dated May 23, 2003, "the holders of WorldCom equity interests shall not receive any distributions on account of such interests. On the effective date, all WorldCom equity interests shall be extinguished." WorldCom plan at §4.08. Return to article

¹⁴ Tharp, Paul, "Winstar is Flying High," New York Post, May 15, 2001, p. 41. Return to article

¹⁵ June 10 Reuters news story. Return to article

¹⁶ June 12 Reuters news story. Return to article

¹⁷ Under the Kmart reorganization plan, a creditors' trust was established for the benefit of Kmart's creditors to pursue all causes of action arising out of certain investigations conducted by the debtors. Except possibly for a minor part of the proceeds, if any, of the creditors' trust, holders of Kmart Corp.'s former common stock will not receive any consideration under the plan. Return to article

¹⁸ Eichenwald, Kurt, "Investors Seem to be Paying Irrational Prices for LTV Shares," The New York Times, Jan. 25, 1993, page D6. Return to article

¹⁹ The Wall Street Journal, Feb. 9, 1993, p. C1. Return to article

²⁰ Russel, et al., supra n. 12. Return to article

²¹ Id. Black-Scholes is a model used to gauge whether options contracts are fairly valued. Return to article

²² Id. Return to article

²³ Rapoport, Michael, "In the Money: Fruit of the Loom Shares Are Worthless," Daily Bankruptcy Review, Nov. 5, 2001, p.7. Return to article